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MASTECH HOLDINGS, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion in conjunction with our audited consolidated financial statements and accompanying notes for the year ended December 31, 2013, included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission ("SEC") on March 21, 2014. This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements about future events, future performance, plans, strategies, expectations, prospects, competitive environment and regulations. Forward-looking statements include all statements that are not historical facts and can be identified by the use of forward-looking terminology such as the words, "may", "will", "expect", "anticipate", "believe", "estimate", "plan", "intend" or the negative of these terms or similar expressions in this quarterly report on Form 10-Q. We have based these forward-looking statements on our current views with respect to future events and financial performance. Our actual financial performance could differ materially from those projected in the forward-looking statements due to the inherent uncertainty of estimates, forecasts and projections and our financial performance may be better or worse than anticipated. Given these uncertainties, you should not put undue reliance on any forward-looking statements. All of the forward-looking statements are qualified in their entirety by reference to the factors discussed under "Risk Factors", "Forward-Looking Statements" and elsewhere in our 2013 Annual Report on Form 10-K. Forward-looking statements represent our estimates and assumptions only as of the date that they were made. We do not undertake any duty to update forward-looking statements and the estimates and assumptions associated with them, after the date of this quarterly report on Form 10-Q, except to the extent required by applicable securities laws. Website Access to SEC Reports: The Company's website is www.mastech.com. The Company's 2013 Annual Report on Form 10-K, current reports on Form 8-K and all other reports filed with the SEC, are available free of charge on the Investor Relations page. The website is updated as soon as reasonably practical after such reports are filed electronically with the SEC. Recent Developments On July 11, 2014, the Company entered into a Second Amended and Restated Loan Agreement (the "Loan Agreement") with PNC Bank, N.A. ("Bank"), replacing its previous Bank credit facility that was set to expire on August 31, 2014. This new facility expires in three years and provides for up to $20 million of credit, subject to a borrowing base and commitment reductions and mandatory prepayments, as described in the Loan Agreement filed as Exhibit 10.1 to the Company's current report on Form 8-K, filed with the SEC on July 17, 2014. See Note 7 of the accompanying financial statements for additional details. On October 22, 2014, the Company's Board of Directors agreed to extend the duration of the Company's existing Share Repurchase Program for an additional two years, through December 22, 2016. Currently there are approximately 495,000 shares yet to be purchased under the program. Critical Accounting Policies and Estimates: The Company's significant accounting policies and critical accounting estimates are described in Note 1 "Summary of Significant Accounting Policies" of the Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies" in our Annual Report on Form 10-K for the year ended December 31, 2013. There were no material changes to these critical accounting policies during the nine months ended September 30, 2014. Overview: We are a domestic provider of IT staffing services to mostly large and medium-sized organizations. From July 1986 until our September 2008 spin-off, we conducted our business as subsidiaries of iGATE Corporation. We do not sell, lease or otherwise market computer software or hardware, and 100% of our revenue is derived from the sale of staffing services. Our IT staffing business combines technical expertise with business process experience to deliver a broad range of services within business intelligence / data warehousing; web services; enterprise resource planning & customer resource management; and e-Business solutions. We provide our services across various industry verticals including: automotive; consumer products; education; financial services; government; healthcare; manufacturing; retail; technology; telecommunications; transportation; and utilities. 17 -------------------------------------------------------------------------------- Table of Contents We have one operating segment. Thus, no segment related disclosures are presented. We do, however, track and evaluate our revenues and gross profits by three distinct sales channels: wholesale IT; retail IT; and permanent placements / fees. Our wholesale IT channel consists of system integrators and other IT staffing firms with a need to supplement their abilities to attract highly-qualified temporary technical computer personnel. Our retail IT channel focuses on clients that are end-users of IT staffing services. Within the retail channel are end-user clients that have retained a third party to provide vendor management services, commonly known in the industry as Managed Service Providers ("MSP"). Permanent placement / fee revenues are incidental revenues derived as by-product opportunities of conducting our core contract staffing business. Economic Trends and Outlook: Generally, our business outlook is highly correlated with general U.S. economic conditions. During periods of increasing employment and economic expansion, demand for our services tends to increase. Conversely, during periods of contracting employment and / or a slowing domestic economy, demand for our services tends to decline. As the economy slowed during the second half of 2007 and recessionary conditions emerged in 2008 and during much of 2009, we experienced less demand for our staffing services. During the second half of 2009, we began to see signs of market stabilization and a modest pick-up in activity levels within certain sales channels and technologies. In 2010, market conditions continued to strengthen over the course of the year and activity levels within most of our sales channels progressively improved. In 2011, 2012 and 2013, activity levels continued to trend -up in most technologies and sales channels. During the first nine months of 2014, activity levels have stabilized and remain largely consistent with the second half of 2013. In addition to tracking general U.S. economic conditions, a large portion of our revenues are generated from a limited number of clients. Accordingly, our trends and outlook are impacted by the prospects and well-being of these specific clients. This "account concentration" factor may cause our results of operations to deviate from the prevailing U.S. economic trends from time to time. In recent years, a larger portion of our revenues have come from our wholesale IT sales channel, which consists largely of strategic relationships with systems integrators and other staffing organizations. This channel tends to carry lower gross margins, but provides higher volume opportunities. This trend in our business mix has impacted overall gross margins during the past several years, and if this trend continues, will likely impact future gross margins as well. Within our retail sales channel, many larger users of IT staffing services are employing MSP's to manage their contractor spending in an effort to drive down overall costs. This trend towards utilizing the MSP model has resulted in lower gross margins in the retail IT channel over the last two years and it is likely that our gross margins will be pressured in future periods should this trend continue. Results of Continuing Operations for the Three Months Ended September 30, 2014 as Compared to the Three Months Ended September 30, 2013: Revenues: Revenues for the three months ended September 30, 2014 totaled $28.6 million, compared to $28.3 million for the corresponding three month period in 2013. This modest year-over-year revenue increase reflected higher demand for the Company's services and the corresponding increase in billable consultants on assignment during the 2014 period, partially offset by a lower average bill rate. Additionally, an early project termination during the second quarter of 2014 had a negative impact on this quarter's revenue performance. Billable consultant headcount at September 30, 2014 totaled 761 consultants compared to 734 consultants, one-year earlier. During the three months ended September 30, 2104, billable consultants on assignment increased by approximately 4-percent. Below is a tabular presentation of revenues by sales channel for the three months ended September 30, 2014 and 2013, respectively: Three Months Ended Three Months Ended Revenues (Amounts in millions) September 30, 2014 September 30, 2013 Wholesale IT Channel $ 22.5 $ 22.2 Retail IT Channel 6.0 6.0 Permanent Placements / Fees 0.1 0.1 Total revenues $ 28.6 $ 28.3 18 -------------------------------------------------------------------------------- Table of Contents Revenues from our wholesale IT channel increased slightly in the three month period ended September 30, 2014 compared to the corresponding 2013 period. Higher revenue levels from our staffing clients (up 5%) were partially offset by modest declines from our integrator clients (down 2%). An early project termination at one of our integrator partners negatively impacted this channel's revenues during the 2014 period. Retail IT channel revenues were flat during the three months ended September 30, 2014, compared to the period one-year earlier as lower revenues from direct end-user clients were essentially off-set by higher revenues from MSP clients. Permanent placement / fee revenues were approximately $0.1 million in both the 2014 and 2013 three month periods ended September 30. For the three months ended September 30, 2014, the Company had three clients that exceeded 10% of total revenues (Accenture = 12.4%, TEK Systems = 10.5% and CGI = 10.2%). For the three months ended September 30, 2013, the Company had one client that exceeded 10% of total revenues (Accenture =12.6%). The Company's top ten clients represented approximately 60% and 56% of total revenues for the three months ended September 30, 2014 and 2013, respectively. Gross Margin: Gross profits in the third quarter of 2014 totaled $5.2 million, or approximately $0.1 million lower than the third quarter of 2013. Gross profit as a percentage of revenue totaled 18.3% for the three month period ending September 30, 2014, which was 60-basis points below our gross margin performance one-year earlier. The margin compression was due to lower margins on new assignments in our wholesale channel and consultant compensation increases in excess of bill rate increases (particularly in the wholesale IT channel). Below is a tabular presentation of gross margin by sales channel for the three months ended September 30, 2014 and 2013, respectively: Three Months Ended Three Months Ended Gross Margin September 30, 2014 September 30, 2013 Wholesale IT Channel 16.9 % 18.1 % Retail IT Channel 21.8 20.8 Permanent Placements / Fees 100.0 100.0 Total gross margin 18.3 % 18.9 % Wholesale IT channel gross margins decreased by 120 basis points for the three months ended September 30, 2014 compared to the 2013 period. This decline reflected both lower margins on new assignments with our integrator clients and consultant compensation increases on existing assignments that have out-paced bill rate increases. Retail IT gross margins were up 100 basis points during the three months ended September 30, 2014 compared to the corresponding 2013 period as margins on new MSP assignments continued to strengthen over the last twelve months, partially offset by consultant compensation increases on existing assignments. Additionally, the Company elected not to pursue new business opportunities with a low-margin MSP client in mid-2013, which favorably impacted overall margins in this channel during 2014. Selling, General and Administrative ("SG&A") Expenses: SG&A expenses for the three months ended September 30, 2014 totaled $3.8 million or 13.2% of revenues, compared to $3.7 million or 12.9% of revenues for the three months ended September 30, 2013. Fluctuations within SG&A expense components during the 2014 period, compared to a year earlier, included the following: • Sales expense in the 2014 period was flat compared to 2013. Higher salary expense related to our new business development efforts was essentially offset by lower bonus expense. • Recruiting expense in the 2014 period was flat compared to 2013. Higher visa processing fees were offset by a decline in domestic staff and lower bonus expense. • General and administrative expense was up $0.1 million in 2014 compared to 2013. Higher facility expenses and corporate related costs (legal / outside services) were partially offset by lower bonus expense. 19 -------------------------------------------------------------------------------- Table of Contents Other Income / (Expense) Components: Other income / (expense) for the three months ended September 30, 2014 consisted of interest expense of ($21,000) foreign exchange losses of ($4,000) and ($8,000) of losses on the disposal of fixed assets, largely related to the move to our new Corporate Headquarters. For the three months ended September 30, 2013, other income / (expense) consisted of interest expense of ($23,000) and foreign exchange losses of ($42,000). The foreign exchange gains and losses were due to fluctuations in the Indian Rupee against the U.S. Dollar. Income Tax Expense: Income tax expense for the three months ended September 30, 2014 totaled $527,000, representing an effective tax rate on pre-tax income of 37.5%, compared to $612,000 for the three months ended September 30, 2013, which represented a 38.0% effective tax rate on pre-tax income. A slightly lower aggregate state tax rate in the 2014 period was responsible for the lower effective tax rate. Results of Continuing Operations for the Nine Months Ended September 30, 2014 as Compared to the Nine Months Ended September 30, 2013: Revenues: Revenues for the nine months ended September 30, 2014 totaled $85.0 million, compared to $78.4 million for the corresponding nine month period in 2013. This 8% year-over-year revenue increase reflected higher demand for our services and the corresponding increase in billable consultants on assignment during the 2014 period. Partially offsetting this higher demand was a major assignment end in the second quarter of 2014 and a slightly lower average bill rate in the 2014 period compared to one-year earlier. Below is a tabular presentation of revenues by sales channel for the nine months ended September 30, 2014 and 2013, respectively: Nine Months Ended Nine Months Ended Revenues (Amounts in millions) September 30, 2014 September 30, 2013 Wholesale IT Channel $ 67.0 $ 60.0 Retail IT Channel 17.8 18.3 Permanent Placements / Fees 0.2 0.1 Total revenues $ 85.0 $ 78.4 Revenues from our wholesale IT channel increased approximately 12% in the nine month period ended September 30, 2014 compared to the corresponding 2013 period. Higher revenue levels from both staffing clients (up 9%) and integrator clients (up 13%) were driven by stronger demand for IT services. An early project termination at one of our integrator partners during the second quarter of 2014 negatively impacted our nine month 2014 revenue growth rate. Retail IT channel revenues were down approximately 3% during the nine months ended September 30, 2014 compared to the period one-year earlier. The decline reflected lower revenues from direct end-user clients, partially offset by higher revenues from our MSP clients. Permanent placement / fee revenues were up approximately $0.1 million in the 2014 period compared to the corresponding period in 2013. For the nine months ended September 30, 2014, the Company had one client that exceeded 10% of total revenues (Accenture = 11.3%). For the nine months ended September 30, 2013, the Company had one client that exceeded 10% of total revenues (Accenture =11.1%). The Company's top ten clients represented approximately 60% and 57% of total revenues for the nine months ended September 30, 2014 and 2013, respectively. Gross Margin: Gross profits for the nine months ended September 30, 2014 totaled $15.6 million, or approximately $0.9 million higher than the corresponding period of 2013. Gross profit as a percentage of revenue totaled 18.3% for the nine month period ending September 30, 2014, which were 40-basis points below our gross margin performance one-year earlier. 20 -------------------------------------------------------------------------------- Table of Contents Below is a tabular presentation of gross margin by sales channel for the nine months ended September 30, 2014 and 2013, respectively: Nine Months Ended Nine Months Ended Gross Margin September 30, 2014 September 30, 2013 Wholesale IT Channel 17.1 % 18.0 % Retail IT Channel 21.7 20.4 Permanent Placements / Fees 100.0 100.0 Total gross margin 18.3 % 18.7 % Wholesale IT channel gross margins decreased by 90 basis points for the nine months ended September 30, 2014 compared to the 2013 period. This decline reflected lower margins on new assignments with our integrator clients and consultant compensation increases on existing assignments that have out-paced bill rate increases. Retail IT gross margins were up 130 basis points during the nine months ended September 30, 2014 compared to the corresponding 2013 period as margins on MSP assignments continued to strengthen over the last twelve months, partially offset by consultant compensation increases on existing assignments. Additionally, the Company elected not to pursue new business opportunities with a low-margin MSP client in mid-2013, which favorably impacted overall margins in this channel during 2014. Selling, General and Administrative ("SG&A") Expenses: SG&A expenses for the nine months ended September 30, 2014 totaled $11.3 million or 13.3% of revenues, compared to $10.9 million or 13.9% of revenues for the nine months ended September 30, 2013. Fluctuations within SG&A expense components during the 2014 period, compared to a year earlier, included the following: • Sales expense increased in the 2014 period by $0.2 million compared to 2013. Higher salary expense related to our new business development efforts were partially offset by lower bonus expense. • Recruiting expense in the 2014 period was down $0.1 million compared to 2013. A slight decline in domestic staff and lower bonus expense were partially offset by higher visa processing fees. • General and administrative expense was up $0.3 million in the 2014 period compared to 2013. Higher travel and other corporate related expenses (legal / outside services) were partially offset by lower bonus expense. Other Income / (Expense) Components: Other income / (expense) for the nine months ended September 30, 2014 consisted of interest expense of ($67,000), foreign exchange gains of $64,000 and ($8,000) of losses on the disposition of fixed assets. For the nine months ended September 30, 2013, other income / (expense) consisted of interest expense of ($77,000) and foreign exchange gains of $4,000. Income Tax Expense: Income tax expense for the nine months ended September 30, 2014 totaled $1.6 million, representing an effective tax rate on pre-tax income of 37.7%, compared to $1.4 million for the nine months ended September 30, 2013, which represented a 37.7% effective tax rate on pre-tax income. Liquidity and Capital Resources: Financial Conditions and Liquidity: At September 30, 2014, the Company had cash balances on hand of $2.5 million, no outstanding debt and approximately $17.4 million of borrowing capacity under our existing credit facility. Historically, we have funded our business needs with cash generated from operating activities. Controlling our operating working capital levels by closely managing our accounts receivable balance is an important element of cash generation. At September 30, 2014, our accounts receivable "days sales outstanding" measurement was 51-days, in-line with historical averages. The Company believes that cash provided by operating activities, cash balances on hand and current availability under our existing credit facility will be adequate to fund our business needs over the next twelve months. Cash flows provided by (used in) operating activities: Cash provided by (used in) operating activities for the nine months ended September 30, 2014 totaled $2.8 million compared to $1.6 million during the nine months ended September 30, 2013. Elements of cash flows in the 2014 period were net income of $2.6 21 -------------------------------------------------------------------------------- Table of Contents million, non-cash charges of $0.4 million, and an offsetting increase in operating working capital levels of ($0.2 million). During the nine months ended September 30, 2013, elements of cash flows were net income of $2.3 million, non-cash charges of $0.4 million, and an offsetting increase in operating working capital levels of ($1.1 million). Discontinued operations for the nine months ended September 30, 2014 provided $31,000 of cash, compared to $1.0 million in the 2013 period. The cash provided in the 2013 period reflected the wind down of retained operating working capital related to the sale of our healthcare staffing business which occurred in August 2013. Cash flows (used in) investing activities: Cash (used in) investing activities for the nine months ended September 30, 2014 totaled ($424,000) compared to ($64,000) for the nine months ended a year earlier. In both 2014 and 2013, capital expenditures accounted for essentially all of our cash needs. The increase in capital expenditures in the 2014 period reflected the relocation to our new suburban Pittsburgh, PA Headquarters. In 2013, discontinued operations provided $1.0 million of cash via the sale of our healthcare staffing business. Cash flows provided by (used in) financing activities: Cash (used in) financing activities for the nine months ended September 30, 2014 totaled ($268,000) and largely consisted of the repurchase of common stock, partially offset by proceeds and excess tax benefits related to the exercise of stock options and vesting of restricted stock and performance shares. Cash (used in) financing activities for the nine months ended September 30, 2013 totaled ($2.6 million) and largely related to the repayment of short-term borrowings. Contractual Obligations and Off-Balance Sheet Arrangements: The Company rents certain office space and equipment under non-cancelable leases which provide for future minimum rental payments. Except for an office lease executed on April 2, 2014 as described in Note 3 "Commitments and Contingencies", total lease commitments have not materially changed from the amounts disclosed in the Company's 2013 Annual Report on Form 10-K. We do not have any off-balance sheet arrangements. Inflation: We do not believe that inflation had a significant impact on our results of operations for the periods presented. On an ongoing basis, we attempt to minimize any effects of inflation on our operating results by controlling operating costs and, whenever possible, seeking to ensure that billing rates are adjusted periodically to reflect increases in costs due to inflation. Seasonality: Our operations are generally not affected by seasonal fluctuations. However, our consultants' billable hours are affected by national holidays and vacation patterns. Accordingly, we generally have lower utilization rates and higher benefit costs during the fourth quarter. Additionally, assignment completions tend to be higher near the end of the calendar year, which largely impacts our revenue and gross profit performance during the subsequent quarter. Recently Issued Accounting Standards: Recent accounting pronouncements are described in Note 15 to the accompanying financial statements. 22 -------------------------------------------------------------------------------- Table of Contents |